Employing Your Family Members

By Scott C Turner, CPA

Hire your kids

instead of paying them an allowance!

It is quite common to see children actively involved in the family business. Even young children can perform valuable services. Many business owners, however, miss out on the major tax savings generated by actually hiring their children and paying them a fair wage for their services.

The expense is tax-deductible to you, and the income is tax-free to them. [Reg Sec 1.162-7(a) ]

The tax-free limit for dependent children was $12,000 per child per year starting in 2018, $12,200 for 2019. The amount is equal to the Standard Deduction. If a child has interest, dividends, capital gain distributions or other investment income, the Standard Deduction is slightly reduced, incurring a small amount of federal tax.

[Rev. Proc. 95-53 and IRC Section § 63(h)(2). TCJA Dec 2017 ]

{Note: For 2019, a child with investment income in excess of $2,200 is taxed at the parents’ income tax rate. See your profit consultant for assistance}

In order to qualify, the wages must be reasonable in amount, based on services actually rendered and documented as paid on a regular and consistent basis as you would an employee from any business.

Children as young as seven years old have been found to qualify as employees of the parents’ business.

[Reference Eller v. Commissioner, 77 T.C. 934 (1981) ]

And if they are family members under 18 working for a sole proprietorship, they are exempt from payroll taxes [IRC Section § 3121(b)(3)(A) and § 3306(c)(5) ] and the business is not required to withhold or to pay Social Security and Medicare taxes. [Tax Court Ruling 48 TC 439, 450 (196) in the case of Denman v. IRS Commissioner]

For incorporated business owners, your corporation will have to pay payroll tax and you do need to withhold social security/medicare from the children’s wages, but the benefits are still well worth it.

Clearly it is more advantageous to employ children through a spouse’s Schedule C (sole proprietor) business rather than through an entity reporting as a corporation for tax purposes.

In order to qualify, the wage rate has to be “reasonable and customary” within your region of the country and within your industry for the type of work being performed. And, of course, always pay your employees (children) on consistently scheduled pay dates, just like you would any other employee.

Because there is no federal or state income tax withholding, and no social security or other tax, for children under 18 the gross pay is the net pay, so there is no need to calculate a net payroll check.

Payroll Reporting

These wages must be paid and the appropriate payroll tax returns and W-2 forms filed with the IRS and Social Security Administration. If children are your only employees, you can report annually to the federal government using Form 944, 940 and W-3/W-2. However, many states require you to report quarterly.

If your spouse also works in your business, the first year you can file annually to the federal government. Thereafter, the IRS will advise you if you need to report payroll quarterly, depending on how much tax and social security/medicare is withheld. To employ an accountant to assist you should only cost a modest fee.

[Revenue Ruling 73-393]

The kids (as employees) should document what they did to earn the money, [Revenue Ruling 73-393] so have them fill out a simple “work log” with headings like:

Date they worked

Type of work performed

Amount of time spent working

Hourly rate you paid them

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